For investors looking to diversify their portfolio internationally, American Depositary Receipts (ADRs) provide an easy way to invest in foreign companies while still trading on U.S. stock exchanges. An ADR represents ownership in the shares of a non-U.S. company that are held by a U.S. depositary bank.
How ADRs Work
Rather than trading a foreign company's shares directly on a U.S. exchange, the depositary bank purchases a bundle of the foreign shares in the company's home market. It then issues ADRs representing those shares that can trade on U.S. exchanges just like regular stocks. Each ADR is equal to some number of the foreign company's shares, with the ratio spelled out in the ADR agreement. For example, one ADR of Spanish banking giant Banco Santander (SAN) represents one ordinary share trading on the Madrid stock exchange. The big advantage of ADRs is that investors can buy shares in overseas companies while still receiving dividends in U.S. dollars and paying in the same currency. This makes it much more convenient than trying to trade the underlying shares cross-border.
Types of ADRs
There are several different types of ADRs available to investors:
Unsponsored ADRs are set up without the cooperation of the foreign company, and they receive minimal assistance from the issuer. These tend to be more thinly traded.
Sponsored ADR programs are created with the approval and cooperation of the foreign company. They have higher compliance requirements but trade more actively. Within sponsored ADRs, there are different "levels" describing how much the company has raised from U.S. investors:
Level 1 trades over-the-counter and cannot be used to raise capital.
Level 2 trades on a major U.S. exchange like the NYSE or Nasdaq.
Level 3 is used to raise capital through a public share offering.
Risks of Investing in ADRs
While ADRs make foreign investment more accessible, they still carry some unique risks compared to domestic stocks:
The companies are subject to different accounting standards, transparency rules, and regulations in their home countries.
There are often different rules around dividends, taxes, and share ownership for ADRs.
Prices can be impacted by fluctuations in the underlying foreign currency exchange rate.
Trading volumes may be lower for ADRs, increasing liquidity risk.
Fees and Expenses
ADRs come with their own set of fees that investors need to be aware of. These can include depositary service fees, custodian fees, currency conversion fees, and dividend fees. The specific fees will vary by ADR and by broker, so it's important to understand the costs involved with any potential ADR investment.
Tax Implications
Investing in ADRs also has some unique tax implications compared to domestic stocks. Any dividends paid will still be subject to the withholding tax rate of the company's home country, though this can sometimes be recovered or reduced. There may also be estate tax considerations for larger ADR holdings. Consulting a tax professional is recommended.
Corporate Actions
When a foreign company undertakes a corporate action like a stock split, dividend payment, rights offering, etc., this will impact the corresponding ADR shares. The depositary bank will try to replicate the effects for ADR holders as closely as possible. However, the process and specific effects can vary depending on the type of corporate action.
Terminations and De-Listings
An ADR program can potentially be terminated if the foreign company decides to stop participating or if the depositary bank chooses to delist the ADRs. If this occurs, the ADRs are usually exchanged for the underlying foreign shares which the investor would then hold directly. This termination process and any fees involved should be reviewed.
Voting Rights
One downside of ADRs is that the voting rights can be curtailed compared to owning the foreign stock directly. Depositary banks have policies around how they will vote the bundled foreign shares underlying the ADRs. Investors should review the depositary bank's voting procedures.
Overall, ADRs provide efficient access to foreign companies, but also involve some unique structures, fees, and considerations that investors need to weigh carefully. As with any investment, thorough research on the ADR specifics is highly recommended prior to investing.
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